Commentary

Facebook stock costs will wipe out profit

Commentary: Rising revenue won’t flow to bottom line

By

JohnShinal

SAN FRANCISCO (MarketWatch) — At its current level of profitability, it will take Facebook Inc. until mid-2013 at the earliest to earn enough operating income just to offset its annual stock-compensation costs.

An analysis of the company’s latest securities filing reveals that unless Facebook
FB, -1.82%
significantly improves its operating margin, these costs — which totaled $2.3 billion as of Sept. 30 — will be enough to prevent the social network from earning a bottom-line profit for at least two more quarters.

That in turn will make its shares less attractive during that time to fund managers and other professional stock buyers who look for value as well as growth when choosing stocks.

Facebook’s massive stock-compensation bill shows the cost to common shareholders of the company’s generosity in handing out equity to employees, executives and early investors. Any net income Facebook might have generated in the near future already has been given away in advance, in the form of free equity, to these insiders.

Because new stock-compensation charges and related taxes will be incurred on Jan. 1, adding to the existing total, Facebook’s per-share earnings may continue to be wiped out by these costs beyond next year.

Facebook’s third-quarter results provided a snapshot of this effect, as those insiders who were free to sell their shares did so in large numbers, generating huge expenses for the company.

Reuters

Mark Zuckerberg

The company reported that operating income fell 9% to $377 million in the quarter, hurt by surging expenses that included $179 million in stock-compensation costs. Further down the income statement, a $431 million quarterly tax charge for stock compensation swung Facebook to a loss of 2 cents a share, compared with a profit of 10 cents a year earlier.

Together these compensation charges and related taxes cost Facebook approximately 20 cents a share in the third quarter, net of a small, related tax benefit.

Each time insiders sell, or when Facebook issues new shares to pay for all or part of an acquisition (as it did when buying Instagram), the company’s compensation bill goes up.

Massively diluted stock

At the root of the problem for Facebook common stockholders is the massive share count. The company has about twice the number of shares outstanding as either Apple Inc.
AAPL, -1.92%
or International Business Machines Corp.
IBM, -1.26%
even though those companies went public decades ago.

Shares
outstanding
for
tech companies

company

outstanding

Microsoft

8.42 billion

Cisco

5.3 billion

Intel

4.98 billion

Facebook

2.17 billion

Yahoo

1.18 billion

IBM

1.13 billion

Apple

941 million

Groupon

653 million

Amazon

453 million

Google

328 million

Data as of third quarter. Source: NYSE

Facebook also has more than six times the number of shares outstanding as Google Inc.
GOOG, -1.72%
which went public in 2004. (See accompanying chart.) Within the tech sector, only long-established bellwether names such as Microsoft Corp.
MSFT, -1.70%
Cisco Systems Inc.
CSCO, -4.02%
Intel Corp.
INTC, -1.79%
and Oracle Corp.
ORCL, -1.42%
have common shares that are more diluted than Facebook’s.

The amount of equity Chief Executive Mark Zuckerberg either kept for himself and employees or sold to pre-IPO investors — such as Goldman Sachs, Russia’s DST and several venture-capital firms — have diluted significantly the stakes available to retail investors in the public markets. On top of that, the company’s IPO was enormous, adding to its share count.

Now whenever insiders and employees sell restricted stock units, Facebook faces additional expenses and a portion of the related taxes owed on the sales. Close to another 800 million Facebook shares will become available for sale this week.

According to its latest filing, Facebook’s $2.3 billion in outstanding compensation costs will be recognized over a period of three years, for an average cost of $767 million per year.

As noted above, Facebook earned operating income of $377 million in the third quarter. In other words, it would take the company slightly more than two quarters of operations just to pay its existing stock-compensation costs.

That’s a hypothetical example, because Facebook could dial back its rate of spending and trade some amount of growth for higher operating margins. But given recent comments made by Zuckerberg, that’s unlikely. Facebook’s third-quarter operating expenses rose twice as fast as revenue.

In the absence of a reduction in spending, Facebook investors should get used to large compensation charges every quarter for at least the next three years, as the company works off its $2.3 billion stock-compensation bill. Those costs will make it much tougher for the company to generate net income.

Stock costs still outstanding

The $431 million tax charge Facebook booked on its third-quarter income statement paid for most of the remaining costs the company has incurred for restricted stock units issued before Jan. 1, 2011, according to its filing.

After expensing slightly more than $1 billion of charges related to those RSUs during the first nine months of 2012, Facebook has $164 million of costs still outstanding for them.

However, the company is still on the hook for $1.87 billion in separate compensation-related expenses for RSUs it issued after Jan. 1, 2011, its filing showed. Facebook expensed $348 million related to that equity plan during the nine months ended in September.

The outstanding costs related to RSUs total $2.04 billion, and Facebook has another $267 million in such costs related to a much-smaller number of preferred shares and stock options. That brings its total outstanding costs related to its compensation plans to $2.3 billion, spread over three years.

Investors looking for these numbers in any reports from Wall Street analysts will be pressed to find them, of course, because analysts covering Facebook’s stock publish earnings estimates that pretend the company hasn’t given away any equity to insiders or employees. But it has, and to a degree that is exceptional even in the tech industry.

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